Tài liệu OUTSIDE DIRECTOR LIABILITY potx

BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM

1055
OUTSIDE DIRECTOR LIABILITY
Bernard Black,
*
Brian Cheffins,
**
and Michael Klausner
***

This Article analyzes the degree to which outside directors of public
companies are exposed to out-of-pocket liability risk—the risk of paying legal
expenses or damages pursuant to a judgment or settlement agreement that are
not fully paid by the company or another source, or covered by directors’ and
officers’ (D&O) liability insurance. Recent settlements in securities class actions
involving WorldCom and Enron, in which lead plaintiffs succeeded in extracting
out-of-pocket payments from outside directors, have led to predictions that such
payments will become common. We analyze the out-of-pocket liability risk facing
outside directors empirically, legally, and conceptually and show that this risk is
very low, far lower than many commentators and board members believe,
notwithstanding the WorldCom and Enron settlements. Our extensive search for
instances in which outside directors of public companies have made out-of-pocket
payments turned up thirteen cases in the last twenty-five years. Most involve fact
patterns that should not recur today for a company with a state-of-the-art D&O
insurance policy.
We offer a detailed assessment of the liability risk outside directors face in
trials under corporate and securities law, including settlement dynamics. We

* Hayden W. Head Regents Chair for Faculty Excellence and Professor of Law,
University of Texas Law School; Professor of Finance, McCombs School of Business,

University of Texas, Austin.
** S.J. Berwin Professor of Corporate Law, Cambridge University, United Kingdom.
*** Nancy and Charles Munger Professor of Business and Professor of Law, Stanford
Law School.
Appendix A lists the firms included in the survey we conducted in connection with this
Article. Many people at those firms were helpful to a degree that went well beyond
answering our survey questions, and we thank all of them. In addition, we thank the
following people for commenting on earlier drafts of this Article: Joe Bankman, Tim Burns,
Yong-Seok Choi, John Coffee, John Core, Joseph Grundfest, Priya Cherian Huskins, Young-
Cheol Jeong, Vic Khanna, Kon Sik Kim, Kate Litvak, Curtis Milhaupt, Chang-Kyun Park,
Katharina Pistor, Mitch Polinsky, Roberta Romano, Leo Strine, and Jay Westbrook, as well
as seminar participants at the Columbia Law School Conference on Global Markets,
Domestic Institutions (2001-2002) (for which an early draft of this Article was written), the
3rd Asian Corporate Governance Conference, Korea Development Institute Conference on
Corporate Governance, the Korean Capital Market and University of Texas Law School, and
the Kirkland & Ellis Law and Economics Workshop. The authors also thank Stephen
Forster, Jim Hawkins, Caroline Elizabeth Hunter, Noah Phillips, and Peter Walgren for
outstanding research assistance, as well as the reference librarians at University of Texas
Law School, especially Tobe Liebert and Kumar Percy, for their extensive assistance in
tracking down details of the cases we report in Part I and Appendix B.
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argue that, going forward, if a company has a D&O policy with appropriate
coverage and sensible limits, outside directors will be potentially vulnerable to
out-of-pocket liability only when (1) the company is insolvent and the expected
damage award exceeds those limits, (2) the case includes a substantial claim
under section 11 of the Securities Act or an unusually strong section 10(b) claim,
and (3) there is an alignment between outside directors’ or other defendants’
culpability and their wealth. Absent facts that fit or approach this “perfect-
storm” scenario, directors with state-of-the-art insurance policies face little out-

of-pocket liability risk, and even in a perfect storm they may not face out-of-
pocket liability. The principal threats to outside directors who perform poorly are
the time, aggravation, and potential harm to reputation that a lawsuit can entail,
not direct financial loss.
INTRODUCTION 1057
I. AN EMPIRICAL INVESTIGATION OF OUTSIDE DIRECTOR LIABILITY 1062
A. Trials: Frequency and Outcomes 1064
B. Out-of-Pocket Payments by Outside Directors in Settlements 1068
C. The Bottom Line 1074
II. WHY IS OUT-OF-POCKET LIABILITY SO RARE? A LEGAL ANALYSIS OF
SECURITIES AND CORPORATE SUITS 1076
A. The Scope of Out-of-Pocket Liability Risk if a Case Is Pursued to
Judgment 1077

1. Securities lawsuits 1077
2. Corporate lawsuits—breach of fiduciary duty 1089
3. The resulting windows of out-of-pocket liability exposure 1095
B. The Effect of Settlement Incentives in Shareholder Suits 1097
1. Securities lawsuits 1098
2. Fiduciary duty suits 1110
C. Lead Plaintiff Motivated To “Send a Message” 1112
1. Solvent company 1114
2. Insolvent company 1116
D. The WorldCom and Enron Settlements: What Factors Allowed the
Lead Plaintiffs To Extract Personal Payments? 1118

1. The WorldCom settlement 1118
2. The Enron settlement 1124
III. OTHER POTENTIAL SOURCES OF OUTSIDE DIRECTOR LIABILITY 1129
A. SEC Enforcement Actions 1131

B. ERISA 1135
CONCLUSION 1138
APPENDIX A. SURVEY DESIGN 1142
APPENDIX B. DETAILS OF SECURITIES AND CORPORATE LAW TRIALS 1146
A. Securities Law Trials 1146
B. Corporate Law Trials 1155
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1057
I
NTRODUCTION
This Article analyzes outside director liability risk empirically, legally, and
conceptually. Concern over liability for outside directors has arisen periodically
since the 1970s, typically in response to specific events that appear to expose
outside directors to heightened risk.
1
Outside director liability is again causing
much concern, with the current trigger being the 2005 securities class action
settlements involving WorldCom and Enron. In these settlements, outside
directors agreed to make substantial payments out of their own pockets to settle
securities class action lawsuits even though there was no evidence in either case
that the outside directors knowingly participated in fraudulent activity.
The WorldCom securities class action arose out of the largest bankruptcy in
U.S. history.
2
The company’s twelve outside directors personally paid $24.75
million as part of a settlement with a plaintiff class led by the New York State
Common Retirement Fund (NYSCRF). The Enron securities class action arose
out of the second-largest bankruptcy in U.S. history; in this case, ten outside
directors paid $13 million out of their own pockets to settle claims against
them. In addition, the Enron outside directors paid $1.5 million to settle a suit

by the U.S. Department of Labor (DoL) under the Employment Retirement
Income Security Act (ERISA). In both settlements, the lead plaintiff insisted on
personal payments by the outside directors. In announcing the WorldCom
settlement, Alan Hevesi, the Comptroller of the State of New York and Trustee
of the NYSCRF, stated that the payments were intended to send “a strong
message to the directors of every publicly traded company that they must be

1. See, e.g., Richard J. Farrell & Robert W. Murphy, Comments on the Theme: “Why
Should Anyone Want To Be a Director?,” 27 BUS. LAW. 7 (1972) (special issue); Larry D.
Soderquist, Toward a More Effective Corporate Board: Reexamining Roles of Outside
Directors, 52 N.Y.U. L. R
EV. 1341, 1341-42, 1362-63 (1977); Companies Expected To Have
Trouble Getting Outside Directors, N.Y.
TIMES, May 9, 1974, at 67. Lax boardroom
practices allegedly contributed to the much-publicized 1970 collapse of railway giant Penn
Central and generated discussion of the role outside directors should play in public
companies. See, e.g., Daniel J. Schwartz, Penn Central: A Case Study of Outside Director
Responsibility Under the Federal Securities Laws, 45 UMKC
L. REV. 394, 395-99 (1977);
Peter Vanderwicken, Change Invades the Boardroom, FORTUNE, May 1972, at 156. In the
1980s, the famous case of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), also led to
widespread concern over outside director liability risk. See, e.g., Michael Bradley & Cindy
A. Schipani, The Relevance of the Duty of Care Standard in Corporate Governance, 75
I
OWA L. REV. 1, 7 (1989); Fran Hawthorne, Outside Directors Feel the Heat, INSTITUTIONAL
INVESTOR, Apr. 1989, at 59. Even earlier there was a concern over the potential liability of
inside and outside directors generally. See, e.g., Joseph Bishop, Current Status of Corporate
Directors’ Right to Indemnification, 69 H
ARV. L. REV. 1057 (1956); Joseph Bishop, Sitting
Ducks and Decoy Ducks: New Trends in the Indemnification of Corporate Directors and

Officers, 77 Y
ALE L.J. 1078 (1968) [hereinafter Bishop, Sitting Ducks]. In each era, these
concerns turned out to be unwarranted.
2. A ranking of U.S. bankruptcies by prefiling assets in millions of dollars can be
calculated from the Bankruptcy Research Database compiled by Professor Lynn LoPucki,
which is available at (last visited Feb. 1, 2006). For instance,
WorldCom’s prefiling asset value is listed as $114.9 billion.
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vigilant guardians for the shareholders they represent. . . . We will hold them
personally liable if they allow management of the companies on whose boards
they sit to commit fraud.”
3

Press reports of the WorldCom and Enron settlements emphasized that they
represented disturbing precedents for outside directors. For example, Richard
Breeden, former chairman of the Securities and Exchange Commission (SEC),
opined that the WorldCom deal “will send a shudder through boardrooms
across America and has the potential to change the rules of the game.”
4
Law
firm client memos supported this view.
5
Many believe that lead plaintiffs in
securities suits will follow the WorldCom and Enron script by seeking personal
payments from outside directors as a condition of settlement and will succeed
in extracting such payments.
Outside directors’ anxiety about legal liability was high prior to the
WorldCom and Enron settlements. The conventional wisdom was that being an
outside director of a public company was risky. Fear of liability has for some

time been a leading reason why potential candidates turn down board
positions.
6
The WorldCom and Enron settlements have heightened these fears.
7

Outside directors are not worried about liability for self-dealing, insider trading,
or other dishonest behavior. These actions indeed entail significant liability
risk, but a director can avoid that risk by refraining from engaging in suspect
actions. Outside directors are concerned instead that, as in WorldCom and
Enron, they will be sued for oversight failures when, unbeknownst to them,
management has behaved badly; that neither indemnification by the company

3. Press Release, Office of the New York State Comptroller, Hevesi Announces
Historic Settlement, Former WorldCom Directors To Pay from Own Pockets (Jan. 7, 2005),

4. Brooke A. Masters & Kathleen Day, 10 Ex-WorldCom Directors Agree to
Settlement, W
ASH. POST, Jan. 6, 2005, at E1; see also John C. Coffee, Jr., Hidden Issues in
“WorldCom,” NAT’L L.J., Mar. 21, 2005, at 13 (“[The] explicit agenda of requiring a
personal contribution has traumatized outside directors . . . .”); Michael W. Early, Protecting
the Innocent Outside Director After Enron and WorldCom, 2 I
NT’L J. DISCLOSURE &
GOVERNANCE 177, 179 (2005) (collecting press quotations).
5. See, e.g., Memorandum, Bailey Cavalieri LLC, D&O Liability: Now It’s Personal
(undated) (on file with authors); Memorandum, Shirli Fabbri Weiss & David A. Priebe,
Partners, DLA Piper Rudnick Gray Cary, Potential for Personal Liability from Recent
Securities Settlements Heightens Importance of Corporate Governance to Directors (Jan. 13,
2005), Memorandum,
Skadden, Arps, Slate, Meagher & Flom, WorldCom/Enron Settlements—Implications for

Directors (Jan. 2005), contentID=51&itemID=998;
Memorandum, Sullivan & Cromwell LLP, WorldCom and Enron—Personal Liability of
Outside Directors, 2-3 (Jan. 10, 2005) (on file with authors).
6. See, e.g., Roberta Romano, What Went Wrong with Directors’ and Officers’
Liability Insurance?, 14 D
EL. J. CORP. L. 1, 1-2 (1989).
7. See, e.g., Michael T. Burr, Securing the Boardroom, C
ORP. LEGAL TIMES, June 5,
2005, at 53; Anne Fisher, Board Seats Are Going Begging, FORTUNE, May 16, 2005, at 204;
Suzanne McGee, The Great American Corporate Director Hunt, I
NSTITUTIONAL INVESTOR,
Apr. 1, 2005, at 32.
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February 2006] OUTSIDE DIRECTOR LIABILITY 1059
nor D&O liability insurance will fully protect them; and that they will therefore
bear “out-of-pocket” liability.
8

We address in a separate article the normative question of the degree to
which outside directors should bear out-of-pocket liability risk for oversight
failures.
9
Regardless of one’s position on the issue, however, all would agree
that, beyond some level of liability risk, qualified people may decide not to
serve as directors and that those who do serve may become excessively
cautious. Too much fear of liability, therefore, may reduce rather than enhance
the quality of board decisions. But before one can assess the proper scope of
outside directors’ out-of-pocket liability risk or the need for reform, one needs
to understand the actual extent of that risk under the current legal regime.
This Article addresses the following questions: How often have outside

directors paid damages, or even legal expenses, out of their own pockets—
either pursuant to a judgment or a settlement? Under what circumstances are
outside directors likely to face out-of-pocket liability when a lawsuit launched
by shareholders or creditors under corporate or securities law goes to trial?
What conditions need to be in place for an outside director to make an out-of-
pocket payment when a shareholder suit settles? How often will lead plaintiffs
such as NYSCRF try to extract out-of-pocket payments from outside directors?
If they try, how likely are they to succeed? Do the WorldCom and Enron
settlements reflect a major change in the underlying dynamics of shareholder
suits that increase the risk of out-of-pocket payments by outside directors in
cases involving oversight failures? Do other sources of risk, such as
enforcement by the SEC or suits brought under ERISA, alter matters by
creating substantial out-of-pocket liability risk?
We begin with the results of an extensive empirical investigation of outside
director liability. We find that out-of-pocket payments by outside directors are
rare. Companies and their directors are frequently sued under the securities
laws and state corporate law, and settlements are common. But the actual
payments are nearly always made by the companies involved—either directly

8. For the purposes of this Article, we define “out-of-pocket liability” to include any
situation in which liability for damages or litigation expenses comes out of the outside
directors’ personal assets—potential costs that are unindemnified and uninsured. We do not
include instances where outside directors representing a major shareholder were found liable
at trial or agreed to pay damages in a settlement, and the major shareholder paid on the
director’s behalf.
9. For partial installments on this project, see Bernard Black, Brian Cheffins &
Michael Klausner, Outside Director Liability: A Policy Analysis, 162 J.
INSTITUTIONAL &
THEORETICAL ECON. (forthcoming 2006) [hereinafter Black, Cheffins & Klausner, Policy
Analysis], and Parts III-IV of Bernard Black, Brian Cheffins & Michael Klausner, Outside

Director Liability (Before Enron and WorldCom) (Working Paper 2004), available at
For an argument in favor of legal liability for directors, see
Lisa M. Fairfax, Spare the Rod, Spoil the Director? Revitalizing Directors’ Fiduciary Duty
Through Legal Liability, 42 H
OUS. L. REV. 393 (2005).
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
1060 STANFORD LAW REVIEW [Vol. 58:1055
or pursuant to directors’ rights to indemnification
10
—or by a D&O insurer, a
major shareholder, or another third party. Since 1980, outside directors have
only once made personal payments after a trial. That was in the famous Van
Gorkom case in 1985.
11
We found an additional twelve cases in which outside
directors made out-of-pocket settlement payments or payments for their own
legal expenses. Ten of those cases involved claims of oversight failure; two
involved duty of loyalty claims; and one involved an allegedly ultra vires
transaction involving the directors’ compensation. (We count two payments by
the Enron outside directors, in a securities case and an ERISA case, as one
instance.) Most of the oversight cases involved fact patterns that should not
recur today for a company with a state-of-the-art
12
D&O insurance policy.
We then explain the rarity of out-of-pocket payments in shareholder suits
by analyzing the complex interaction of multiple factors: (1) substantive
liability rules; (2) procedural hurdles that plaintiffs must overcome to win a
damage judgment against outside directors; (3) indemnification and D&O
insurance, which prevent “nominal liability”
13

for settlement payments,
damage awards, or legal expenses from turning into out-of-pocket liability; and
(4) settlement incentives. Our analysis reveals a narrow set of circumstances in
which outside directors face a risk of a judgment against them that could result
in out-of-pocket liability. Setting aside self-dealing and other dishonest
behavior, the window of exposure was narrow prior to WorldCom and Enron,
and it remains narrow today.
14

We next analyze settlement incentives that arise in the shadow of the
outside directors’ exposure to an actual finding of liability following a trial.
Settlement incentives sharply narrow the already limited level of out-of-pocket
liability risk. Once settlement incentives are considered, outside directors face
significant risk primarily in two situations. One situation, which we call a
“perfect storm,” requires the confluence of the following elements: (1) the
company is insolvent and the expected damage award exceeds the amount the
company can pay plus the limit on the company’s insurance policy; (2) the case
includes either a large claim under section 11 of the Securities Act of 1933
(Securities Act) or a large and unusually strong claim against the outside
directors under section 10(b) of the Securities Exchange Act of 1934
(Exchange Act); and (3) there is an alignment between individual culpability

10. In most settlements, the issue of whether a payment is made on behalf of outside
directors or by the company directly is avoided. The company and the D&O insurer fund a
settlement, and the parties agree that the defendants do not acknowledge a violation.
11. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
12. See infra note 121 and accompanying text.
13. We define “nominal liability” to include situations in which a court has held
outside directors liable for damages or an outside director agrees to a settlement, but where
the actual payments for damages and legal expenses are made by the company, the D&O

insurer, a major shareholder, or another third party.
14. We analyze corporate and securities law cases in detail and address ERISA and
other laws in less detail. We do not include liability for insider trading in our analysis.
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1061
and personal wealth among the officers, directors, or both. Even if these
conditions are met, however, an outside director may still be protected from
out-of-pocket liability if his company provides its directors with supplemental
insurance coverage that is separate from that covering the company and the
inside managers. Perfect storms have happened and they can happen again, but
they are rare.
The second out-of-pocket liability scenario, which we call “can’t afford to
win,” occurs when the company is insolvent, and, due to a lack of D&O
insurance or insufficient coverage, an outside director must pay his own
litigation expenses to defend a suit. Under these conditions, even a director
facing a meritless lawsuit may incur legal expenses, make an out-of-pocket
payment to settle, or do both, rather than defend a case further. This risk should
not be a substantial concern today for a well-counseled board. Virtually all
companies now carry D&O insurance at levels that will cover litigation
expenses. Furthermore, companies can now purchase separate Side A Only
policies or traditional policies with severability clauses in order to preserve
outside directors’ coverage irrespective of inside managers’ conduct.
15

Commentators have suggested that WorldCom and Enron will encourage
other lead plaintiffs to attempt to extract out-of-pocket payments from outside
directors.
16
Even if this is true (a point that remains unsubstantiated), there are
substantial constraints on a lead plaintiff’s ability to translate a desire for

personal payments into actual payments. Absent a perfect storm, a lead plaintiff
in a securities class action can pursue personal payments from outside directors
only by sacrificing the interest of the class in maximizing the net present value
of the eventual recovery, thus likely violating a duty owed to the class and
potentially posing a similar risk for the class counsel. Even if a lead plaintiff
and class counsel are willing to go after outside directors’ personal assets under
those circumstances, the effort to extract personal payments is likely to fail
unless the lead plaintiff can credibly threaten to litigate a case to a judgment
that will require the outside directors to make out-of-pocket payments. To make
this threat credible, the company must be insolvent, and the other perfect-storm
elements must be present to a substantial degree—we call this a near-perfect
storm—which is still a rare convergence of factors. WorldCom and Enron fit
the perfect or near-perfect-storm pattern.

15.See Early, supra note 4, at 184-86.
16. See, e.g., Coffee, supra note 4 (noting that the NYSCRF agenda to require personal
contributions is “being copied by other public pension funds”); John R. Engen & Charlie
Deitch, “Chilling” (What Directors Think of the Enron/WorldCom Settlements), CORP.
BOARD MEMBER, Mar./Apr. 2005, available at
hive.pl?articleid=12143&V=1; Fisher, supra note 7; Charles Hansen, A Seismic Shift in
Director Liability Exposure: The WorldCom and Enron Settlements, C
ORPORATION, July 15,
2005; Joann Lublin, Theo Francis & Jonathan Weil, Directors Are Getting the Jitters; Recent
Settlements Tapping Executives’ Personal Assets Put Boardrooms on Edge, W
ALL ST. J.,
Jan. 13, 2005, at B1; McGee, supra note 7; Peter Wallison, The WorldCom and Enron
Settlements: Politics Rears Its Ugly Head, F
IN. SERVS. OUTLOOK, Mar. 2005.
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Enforcement actions by the SEC and the DoL pose some additional risk to
outside directors. Our search, however, uncovered only one instance in which
an SEC enforcement proceeding yielded an out-of-pocket payment by an
outside director, and this situation involved self-dealing rather than a failure to
exercise sufficient oversight. There has also been only one DoL enforcement
action under ERISA that has resulted in a personal payment by outside
directors: the action against the Enron board. The bottom line is that, despite
the litigious environment in which public companies function, outside director
liability is, and will in all likelihood remain, a rare occurrence, particularly for
companies with state-of-the-art D&O insurance.
I.
AN EMPIRICAL INVESTIGATION OF OUTSIDE DIRECTOR LIABILITY
Because the WorldCom and Enron settlements are recent, large, and highly
visible, they weigh heavily in the perceptions of outside directors, lawyers, and
commentators. But how common has out-of-pocket liability been for outside
directors of public companies?
17
Many lawsuits are filed seeking damages, but
how many lead to trials, and how many lawsuits end with out-of-pocket
payments by outside directors, either in a settlement or after a trial? No data
have been collected to address this question. Moreover, collecting complete
data from public records is impossible because the vast majority of shareholder
suits settle without a trial, information about trials and settlements is difficult to
track through court records (despite being technically public), and settlement
documentation often leaves unclear the sources of payments (sometimes
deliberately so). Even for trials, there is no public record of who actually paid
damage awards—officers or directors, their company, the D&O insurer, a
major shareholder, or another third party.
Lacking a comprehensive source of information about either trials or out-
of-pocket payments following trials or settlements, we adopted a multi-prong

approach to investigating both. We read widely in the D&O literature and
searched for news stories in the legal and business press and in practitioner-
oriented journals dealing with director liability and D&O insurance. We
conducted Westlaw searches for corporate law cases that had gone to trial in

17. For the purposes of this study, we defined outside director broadly to encompass
any director of a public company not serving in a managerial capacity. If an individual
served as an executive during the period of alleged wrongdoing and subsequently became an
outside director by giving up his managerial duties, we treated him as an inside manager. For
instance, a securities lawsuit involving Symbol Technologies settled in 2004 with company
founder Jerome Swartz paying $4 million. He was CEO during part of the period when the
alleged securities fraud occurred (2000 to 2002) and a director during the entire period. We
treated him as an inside manager. For background, see Complaint, Gold v. Razmilovic, 2003
WL 23712371 (Del. Ch. Dec. 18, 2003); Press Release, Bernstein Litowitz Berger &
Grossmann LLP, Louisiana and Miami Pension Fund Lead Plaintiffs Announce $139
Million Partial Settlement of Securities Litigation Against Symbol Technologies Inc. (June
3, 2004),
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1063
which outside directors had been sued for damages, and we searched SEC
litigation releases for payments resulting from SEC enforcement.
18
Our search
covered the period from 1980 through the end of 2005.
In addition, we conducted an extensive telephone survey of (1) law firms
with large securities litigation practices, on both the defense and plaintiff sides;
(2) leading Delaware firms specializing in corporate litigation; (3) lawyers that
represent insurers as monitoring counsel; (4) lawyers specializing in D&O
insurance; (5) in-house legal counsel at major public pension funds that often
act as lead plaintiffs; (6) major D&O insurance brokers; (7) major D&O

insurers; and (8) current and former SEC officials. We followed up on leads as
to possible trials or instances of out-of-pocket liability. Sometimes we had to
speak to or investigate several sources about a single case to be sure we had a
full picture. Not infrequently, when one source thought outside directors had
paid personally, other sources revealed that the payment was covered by
insurance or indemnification or that the director in question was an inside
manager. Our interviews included one or more senior partners at each of
twenty-four plaintiffs’ law firms and sixty-seven law firms that primarily
represent either defendants or insurers or both, and one or more senior
executives at eight major D&O insurance companies and seven D&O insurance
brokers. Appendix A provides details on our survey methodology and a list of
the firms we interviewed. In the end, we may have missed some trials and out-
of-pocket payments, especially earlier ones as to which memories may have
faded, but it is unlikely that we missed many.
Our empirical investigation did not cover insider trading. We did, however,
cover SEC enforcement proceedings involving other forms of self-dealing or
failures of oversight. In addition, we sought to find trials and out-of-pocket
settlements arising under ERISA, under which directors who exercise authority
over employee retirement plans that hold company shares can be held liable as
fiduciaries for plan losses.
19

We find that while lawsuits are common—securities class actions alone
come to roughly 200 cases per year—but trials are uncommon. When cases
settle, as the vast majority do, plaintiffs often recover cash, but the cash nearly
always comes from the company, a D&O insurer, a major shareholder, or
another third party. Outside directors make personal payments in a tiny
percentage of cases. From 1980 onwards—as far back as we looked—we found

18. Details on the searches are provided at various points in this Part, Part III, and

Appendices A and B. Most corporate law cases are tried in Delaware before a chancery court
judge, who writes an opinion. Thus, a search that covers decided cases should capture most
corporate trials. Securities class actions, in contrast, are almost invariably tried to juries, so
an online search for judicial opinions would not capture them.
19.See In re Schering-Plough Corp. ERISA Litig., 420 F.3d 231, 231-32 (3d Cir.
2005) (giving plaintiffs who invest in company shares under a 401(k) plan standing to sue on
behalf of the plan and recover damages for losses due to a fiduciary-duty breach). Among
ERISA cases, we examined only those in which employees claimed damages for losses on
company shares.
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1064 STANFORD LAW REVIEW [Vol. 58:1055
a total of thirteen cases in which outside directors made out-of-pocket
payments. This includes payments pursuant to judgment, payments to settle
cases, and payments simply to cover legal expenses until a case was resolved.
Ten of these cases involved oversight failure, two involved self-dealing or duty
of loyalty claims, and one involved a claim that a transaction involving
directors’ own compensation was ultra vires.
Most cases in which outside directors made out-of-pocket payments have
involved small companies and little or no publicity. Of the thirteen cases we
found, four are well known (WorldCom, Enron, Tyco, and Van Gorkom). One
is little known but could in principle be found through a careful search of news
stories (Independent Energy Holdings). The remaining cases are either entirely
hidden or the existence of out-of-pocket payments can be inferred only by
piecing together multiple sources of information.
20

A. Trials: Frequency and Outcomes
The volume of shareholder litigation is considerable. According to the
securities litigation database maintained by the National Economic Research
Associates (NERA), 3239 federal securities cases were filed against public

companies between 1991 (when NERA began to collect this data) and 2004.
21

That does not include state fiduciary duty cases or state securities law cases.
Very few cases, however, go to trial. We looked back to 1980, and as Table
1 indicates, we uncovered only thirty-seven securities law cases seeking
damages that were tried to judgment against public companies, their officers
and directors, or both. Thirty-three cases were brought in federal court under
the federal securities laws. Thirty-one of those were class actions and two were
individual actions.
22
We also found five state securities law cases that were

20. Our findings are consistent with historical patterns. According to a 1944 judgment
of the New York Supreme Court, “it is only in a most unusual and extraordinary case that
directors are held liable for negligence in the absence of fraud, or improper motive, or
personal interest.” Bayer v. Beran, 49 N.Y.S.2d 2, 6 (1944). Professor Joseph Bishop found
in 1968 “that cases in which directors of business corporations are held liable, at the suit of
stockholders, for mere negligence [without self-dealing] are few and far between.” Bishop,
Sitting Ducks, supra note 1, at 1095. With respect to derivative suits, Bishop famously
reported: “The search for cases in which directors of industrial corporations have been held
liable in derivative suits for negligence uncomplicated by self-dealing is a search for a very
small number of needles in a very large haystack.” Id. at 1099.
21. On filed cases, see
ELAINE BUCKBERG ET AL., NERA ECONOMIC CONSULTING,
RECENT TRENDS IN SHAREHOLDER CLASS ACTION LITIGATION: BEAR MARKET CASES BRING
BIG SETTLEMENTS (2005). Multiple complaints involving similar facts are counted as a single
case. Similar but somewhat smaller numbers are reported in PRICEWATERHOUSECOOPERS
LLP, 2004 SECURITIES LITIGATION STUDY (2005), and in CORNERSTONE RESEARCH,
SECURITIES CLASS ACTION FILINGS, 2005: A YEAR IN REVIEW 3 (2005), which relies on the

Stanford Securities Class Action Clearinghouse, available at
22. Our count of securities trials includes one trial that ended in a hung jury, which
was settled prior to retrial.
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1065
tried to judgment. One case included both federal and state claims and is
included in our count of state and federal cases (but only as one case in the
thirty-seven total cases).
23
Appendix B provides details on completed trials as
well as eleven additional cases against companies, officers, or directors that
settled during trial. It also lists a number of securities law trials against third-
party defendants, including accounting firms, investment banks, and others.
Table 1. Securities and Corporate Law Trials Against Public Companies and
Their Directors for Damages, 1980-2005
Area of Law
(State or Federal
Court)

Total Cases
Tried to
Judgment

Trial Includes
Outside
Directors

Plaintiff Win
Against
Outside

Directors

Damages Paid
by Outside
Directors

Securities—
Federal Court

33 7 0 0
Securities—State
Court

5 3 1 0
Corporate
(Fiduciary Duty)
—Derivative

Data Not
Available

5 2 0
Corporate
(Fiduciary Duty)
—Direct

Data Not
Available

12 4 1

ERISA (Fiduciary
Duty; Losses on
Company Shares)

0 0 0 0

In only eight
24
completed securities trials were outside directors named as
defendants when the trial began. In one of those cases, the outside directors
settled during trial within D&O insurance policy limits. In six others, the suit
against the outside directors failed. In each of these cases the outside directors
involved faced little out-of-pocket risk even if they had lost at trial because the

23. Since 1998, shareholder class actions under state securities laws have been largely
preempted by federal law. See Securities Litigation Uniform Standards Act of 1998, Pub. L.
No. 105-353, 15 U.S.C. § 77p (2006); Exchange Act § 28(f), 15 U.S.C. § 78bb(f) (2006);
R
OBERT W. HAMILTON, THE LAW OF CORPORATIONS 572-73 (5th ed. 2000). Class actions
were common for a brief period in the mid-1990s, when plaintiffs were seeking to escape
restrictive rules introduced under the Private Securities Litigation Act of 1995. One study of
securities cases filed in state court between 1996 and 1998 found forty-nine such cases. See
P
RICEWATERHOUSECOOPERS LLP, 2002 SECURITIES LITIGATION STUDY 1 (2002). Individual
actions (with fewer than forty-nine shareholder plaintiffs) under state law remain viable and
are sometimes brought. See, e.g., Amended Consolidated Complaint, Peregrine Litig. Trust
v. Moores, Consol. Case No. GIC 788659 (Cal. Super. Ct. 2004).
24. The one case that was tried in both federal and state court included outside
directors among the defendants. Thus, the total number of securities trials in Table 1 is ten
rather than nine.

BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
1066 STANFORD LAW REVIEW [Vol. 58:1055
defendant companies were solvent and thus could have indemnified them.
25

The only case since 1980 in which plaintiffs have won a damage award
against an outside director in a securities case involved computer disk drive
maker MiniScribe. After MiniScribe got into financial trouble, an investment
bank invested in MiniScribe and sent a “company doctor” to run the business.
26

The investment bank’s founder joined MiniScribe’s board and audit committee
as an outside director. A financial fraud ensued, followed by both federal and
Texas state securities litigation. In the state case, the jury awarded $530 million
in punitive damages and $20 million in actual damages to the plaintiffs,
including a large award against the founder of the investment bank.
27
In a post-
trial settlement, the investment bank paid on behalf of its founder. Other than
MiniScribe, one has to go back to before 1980 to find securities cases where
outside directors were found liable in court.
28

Table 1 also summarizes the trials we found involving state corporate law
fiduciary duty claims for damages against outside directors.
29
There is no
comprehensive count of fiduciary duty damage actions filed. Randall Thomas
and Robert Thompson reported that in 1999 and 2000, a total of 294 cases were
filed against public companies in Delaware Chancery Court.

30
This figure,
however, includes cases seeking damages and those seeking injunctions.
Thomas and Thompson also do not identify cases in which outside directors
were defendants. Our search for trials of damages actions against outside
directors of public companies uncovered five derivative suits since 1980. Some
of those cases include direct claims along with derivative claims. In only two
cases, ASG Industries and In re MAXXAM, Inc./Federated Development
Shareholders Litigation, did the plaintiff win. ASG was a freeze-out case,
which apparently settled after trial with modified terms and no payment by
directors. In MAXXAM, the trial judge did not rule on damages, and the case
settled with D&O insurers paying $7.5 million on behalf of the directors.
31


25. We discuss indemnification in Part II, infra.
26. For details, see Kevin Moran, Disk Maker Faces Fraud Judgment/Accountants
Also Cited in Verdict, H
OUS. CHRON., Feb. 5, 1992; Kathleen Pender, Hambrecht & Quist
Reels from Lawsuits in MiniScribe Fiasco, S.F.
CHRON., Apr. 27, 1992, at B1.
27. The lawsuits filed in federal court settled prior to trial. See Gottlieb v. Wiles, 150
F.R.D. 174, 178 (Colo. 1993). On who paid what, see Pender, supra note 26, at B1.
28.See Gould v. Am Hawaiian S.S. Co., 535 F.2d 761, 776-78 (3d Cir. 1976)
(granting summary judgment on liability against outside director in 1971 in a § 14(a) case,
but with an overlay of self-dealing because the director was employed by and represented a
major shareholder who received favorable treatment in a merger); Escott v. Barchris Constr.
Corp., 283 F. Supp. 643, 688-89 (S.D.N.Y. 1968) (finding two outside directors liable, one
of whom was the company’s outside legal counsel).
29. For details on the electronic searches we ran, see Appendix B, infra.

30. Robert B. Thompson & Randall S. Thomas, The New Look of Shareholder
Litigation: Acquisition-Oriented Class Actions, 57 V
AND. L. REV. 133, 169 (2004).
31.See In re MAXXAM, Inc./Federated Dev. S’holders Litig., No. CIV.A. 12111,
CIV.A. 12353, 1997 WL 187317, at *30-31 (Del. Ch. Apr. 4, 1997); David Ivanovich, 6
Year Legal Battle Between 2 Texas Investors Ends in Delaware Court, HOUS. CHRON., Dec.
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1067
We also found twelve direct shareholder suits tried to judgment where
plaintiffs sought damages and outside directors were defendants. The plaintiffs
were successful in four of these cases, but only in Van Gorkom were there out-
of-pocket payments by outside directors. In that case, the directors of a
takeover target, Trans Union, were sued for breach of the duty of care in selling
their company without adequately informing themselves. The trial court found
in favor of the directors, but the Delaware Supreme Court reversed.
32
The case
was remanded and ultimately settled before damages were awarded. The
settlement was for $23.5 million, which exceeded Trans Union’s $10 million in
D&O coverage. The public story is that the acquirer, controlled by the Pritzker
family, voluntarily paid the damage award against the directors, and the
Pritzkers asked only that each director make a charitable contribution equal to
ten percent of the damages exceeding the D&O coverage ($135,000 per
person).
33

The full story is more complex. Because the lawsuit was direct rather than
derivative, indemnification was permissible under Delaware law, as long as the
directors acted in good faith. Trans Union, like almost all public companies,
had committed to indemnify its directors to the full extent permitted by law. It

is unclear from public accounts why the outside directors were not simply
indemnified by Trans Union (an obligation the acquirer would assume in the
merger). One might infer that the acquirer disputed Trans Union’s obligation to
indemnify the directors and that the directors’ payments to charity reflected a
compromise of that dispute.
34

For ERISA fiduciary duty cases involving losses on employee-held
company shares, we relied on a 2005 study by Cornerstone Research and on
our own survey to find cases that have gone to trial.
35
The number of ERISA
suits is growing quickly—Cornerstone found seventy-five ERISA class action
suits filed between 1997 and mid-2005—and there have been some large
settlements.
36
Cornerstone, however, found no trials involving ERISA claims,

9, 1997.
32. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
33.See Roundtable Discussion: Corporate Governance, 77 CHI KENT L. REV. 235,
237-38 (2001) (quoting Robert Pritzker as saying that the Pritzkers paid ninety percent and
the outside directors paid ten percent—a total of $1.35 million—to charity). The Trans
Union CEO, Mr. Van Gorkom, made the contributions on behalf of several directors for
whom this would have been a financial strain. Id.
34. For the outside directors, the basis for the acquirer to dispute indemnification is not
clear. Case law on indemnification was sparse at the time, but current Delaware case law is
strongly pro-indemnification, so a similar dispute would be unlikely to arise today.
35.See C
ORNERSTONE RESEARCH, ERISA COMPANY STOCK CASES (2005).

36. On the fact that the number of ERISA fiduciary duty suits by employees claiming
losses on company shares is growing, see Leigh Jones, A “Perfect Storm” for Pension
Suits?, N
AT’L L.J., Dec. 13, 2004, at 1. Large ERISA settlements include lawsuits involving
Enron (discussed in Part IV, infra), Global Crossing Ltd. (settlement for $79 million), and
Lucent Technologies ($69 million). See Stephen J. Weiss & Shannon A.G. Knotts, Look into
Fiduciary Liability Insurance: This Policy Fills in a Big Gap Left by D&O Insurance,
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
1068 STANFORD LAW REVIEW [Vol. 58:1055
nor did we.
B. Out-of-Pocket Payments by Outside Directors in Settlements
While trials are uncommon, a great many securities, corporate, and ERISA
suits settle.
37
For instance, according to NERA’s securities litigation database,
of the 3239 federal securities cases filed against public companies between
1991 and 2004, 1754 had settled by the end of 2004.
38
Of those suits filed that
do not settle, many either do not survive a motion to dismiss or a motion for
summary judgment, or they simply disappear quietly, meaning that the
plaintiffs do not pursue the case and the defendants let sleeping lawsuits lie.
39

Since settlements are so common, we investigated whether outside
directors have made out-of-pocket payments pursuant to settlement agreements.
The only generally known instances in which outside directors made out-of-
pocket payments to settle securities, corporate, or ERISA claims involved
WorldCom, Enron, and proceedings brought by the SEC against an outside
director of Tyco.

40

Our empirical investigation unearthed nine additional
settlements since 1980 in which outside directors made out-of-pocket
payments.
41
These cases, at least as a practical matter, are not publicly known.

DIRECTORS & BOARDS, June 22, 2005, at 12.
37.See C
ORNERSTONE RESEARCH, supra note 35 (finding that of seventy-five ERISA
class actions brought since 1997, twenty-five had settled); Roberta Romano, The
Shareholder Suit: Litigation Without Foundation?, 7 J.L.
ECON. & ORG. 55, 57-60 (1991)
(arguing that incentives to settle are especially high in corporate law cases and finding that
out of 128 lawsuits brought against a sample of 535 public companies, 64.8% of the cases
settled out of court); see also Thomas M. Jones, An Empirical Examination of the Resolution
of Shareholder Derivative and Class Action Lawsuits, 60 B.U.
L. REV. 542, 545 (1980)
(finding that settlements were common in corporate cases in the 1970s); cf. Thompson &
Thomas, supra note 30, at 178 (finding that among corporate lawsuits filed in the Delaware
Chancery Court in 1999 and 2000, only 28.1% of those involving public companies settled).
38. B
UCKBERG ET AL., supra note 21. Other than the cases identified above as having
gone to trial, the remainder were either dismissed or are still pending. Some cases that are
technically still pending have likely been abandoned by the plaintiffs. NERA tracks
dismissals but does not try to identify cases that become indefinitely inactive.
39. Many suits under corporate law settle without any monetary payments by
defendants. See Thompson & Thomas, supra note 30, 179-81 (finding in a study of
Delaware corporate litigation that approximately half of settlements fail to provide monetary

recovery); Romano, supra note 37, at 61 (finding that nearly half of the settlements in her
study failed to provide for a monetary recovery)
40. Technically, Van Gorkom was a settlement as well. As discussed above, the parties
settled after a trial, appeal, and remand. We discuss it in the previous Part in the discussion
of trials.
41. Although we did not systematically search for out-of-pocket payments prior to
1980, our research uncovered several cases dating from 1968 to 1979 in which out-of-pocket
payments possibly occurred, though none are confirmed. During this time period, securities
litigation was in its infancy and D&O insurance coverage was far from universal. If a
company without D&O insurance went bankrupt and a securities lawsuit followed, directors
faced substantial out-of-pocket risk.


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February 2006] OUTSIDE DIRECTOR LIABILITY 1069
The payments involved include settlement payments and payments outside
directors made simply to cover their own legal expenses pending resolution of a
case—even if no settlement payment was ever made.
42
Table 2 provides a
summary, dividing cases into three categories: oversight failures, self-dealing
and other loyalty breaches, and one case of an ultra vires transaction.
The most significant of the nonpublic settlements, in terms of dollars paid,
was a securities class action settlement described to us on a no-names basis by
two separate sources and labeled in Table 2 as Confidential Case #1.
43
This
case was resolved in the early 2000s and involved a serious oversight failure in
the context of an alleged accounting fraud that ended in the company’s
insolvency. Several directors each paid a mid-six-figure amount to settle the

case. D&O coverage was low in relation to damages claimed and was contested
by the insurer on the basis of application fraud.
44
The maximum amount the
insurer was willing to pay, taking into account its potential defense to paying at
all, could have been exhausted if the case had gone to trial.
The other nonpublic oversight cases also involved insolvent companies
with serious D&O coverage problems. Ramtek and Baldwin-United had not
purchased D&O insurance at all. Ramtek was a Silicon Valley pioneer in
computer graphics. During the 1980s it apparently was reasonably common for
publicly held Silicon Valley companies to go without D&O coverage. The hope
was that companies without insurance would be less likely to be sued.
However, as plaintiffs’ counsel familiar with the era explained to us, there was

One possible case is the classic first decision finding liability under Securities Act § 11,
Escott v. Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). Two outside
directors were found liable: Auslander, who admitted doing no diligence whatsoever before
signing the prospectus for Barchris Construction’s debenture offering; and Grant, who was
also the company’s outside counsel and was held to a higher diligence standard. The
accountants, investment bankers, and insiders were also found liable. The case then settled,
apparently for $780,000. An op-ed article, written several years later, asserts that the
directors paid some of this amount, but we could not confirm this. See Michael C. Jensen,
Corporate Boards Rise to Challenge: Directors Find Passive Role Leads to Lawsuits, N.Y.

TIMES, Dec. 28, 1975; see also Mooney v. Vitolo, 301 F. Supp. 198, 199 (S.D.N.Y. 1969)
(mentioning the settlement, dismissing a related claim against the directors for fraud and
waste under New York corporate law). If Barchris lacked D&O coverage, which was not
standard at the time, the directors likely also paid their own legal fees.
One source also reported to us two Oregon cases in the early 1970s involving small,
intrastate offerings. The companies involved, Cryo-Freeze and SDS, went bankrupt and

lacked D&O insurance. Our source indicated that when securities suits brought against the
companies settled, their directors made out-of-pocket payments. It is unclear whether any
directors who paid were outside directors.
42. We did not seek to identify instances in which an outside director paid to settle a
case but was indemnified by a major shareholder he represented, such as a venture capitalist,
a private equity fund, or other institutional investor. We are aware of one such case (the
details of which are confidential); it is possible that there are others.
43. The details of the sources of payment in the settlement agreement were
confidential.
44. The nature of application fraud is described in Part II, infra.
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
1070 STANFORD LAW REVIEW [Vol. 58:1055
no way for them to know whether a company had D&O insurance before a suit
was filed. In Ramtek, two outside directors who were members of the audit
committee paid a combined $300,000 in the settlement, plus legal fees.
45

Baldwin-United was an insurance company that sold these policies, but it had
not purchased D&O insurance itself. The result was that its directors paid legal
expenses to defend against a securities suit.
46
It appears, however, that they did
not make a settlement payment.
47

Table 2. Out-of-Pocket Payments by Outside Directors, 1980-2005
Company
Type of
Case
Year

Company
Solvent
D&O
Insurance

Number
of
Directors

Sued
Nature
of
Payment

Total
Payment by
Outside
Directors
Oversight Failures (Ranked by Size of Payment)
WorldCom
Securities
§ 11
2005

No Contested

12 Settlement

$24.75

Million
Securities
§ 11
2005

Yes 10 Settlement

$13 Million

Enron
ERISA /
DoL
2004

No
Yes
(ERISA
Cover-
age)
11 Settlement

$1.5
Million
Independent
Energy
Holdings
Securities

§ 11
2003

No
Low,
Contested

4 Settlement

Portion of
$2 Million
Paid by
Directors &

Officers
Confidential
Case #1
Securities

§ 11
~2000

No
Low,
Contested

Several,
Exact
Number
Not
Disclosed

Settlement

Low $
Millions

45.See In re Ramtek Sec. Litig., No. C 88-20195 RPA, 1991 WL 56067 (N.D. Cal.
Feb. 4, 1991). Our information is based on interviews with plaintiff’s counsel, underwriters’
counsel, and defense counsel.
46.See Directors Quit at Baldwin, N.Y. TIMES, Jan. 25, 1985, at D13 (explaining that
seven outside directors resigned and that bankruptcy examiner recommended lawsuits
against them and Baldwin’s executive chairman); see also In re Baldwin-United Corp., 43
B.R. 443 (S.D. Ohio 1984) (reversing bankruptcy judge’s order allowing advancement of
legal expenses to former directors who were defendants in the securities class action, but
allowing advancement of expenses for then-current directors); Judge To Rule on Baldwin
Settlement, A
SSOCIATED PRESS, Dec. 24, 1986 (describing the $10.6 million settlement of
securities class action with holders of Baldwin shares and debentures, law firm, accounting
firm underwriter, and “former Baldwin-United Corp. officials” that are among those
contributing; plaintiffs’ counsel comments that they needed to “try to find the deep pockets”;
and Baldwin-United’s directors and officers did not have liability coverage).
47. One source reported that the directors did make a settlement payment, perhaps in
another suit on behalf of annuity holders, but we could not confirm this.
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1071
Company
Type of
Case
Year

Company

Solvent
D&O
Insurance

Number
of
Directors

Sued
Nature
of
Payment

Total
Payment by
Outside
Directors
Van Gorkom

Duty of
Care
1985

Yes Yes 10 Settlement

$1.35
Million
Ramtek
Securities
§§ 10(b), 11

1992

No No 2
Settlement
& Legal
Fees
$300,000
Plus Legal
Fees
Baldwin-
United
Securities
§ 10(b)
1985

No No Several Legal Fees

Unknown
Confidential
Case #2
Securities

§ 10(b)
~2000

No
Low,
Contested

Several,
Exact
Number
Not
Disclosed

Legal Fees

~$50,000
Confidential
Case #3
Creditor
Suit, Duty
of Care
Mid-
2000s

No
Low,
Contested

Several,
Exact
Number
Not
Disclosed

Settlement

$300,000-

400,000
Peregrine
Securities
§ 11
2000s

No
Low,
Contested

Several Legal Fees

Unknown,
Case
Ongoing
Self-Dealing and Duty of Loyalty Cases
Tyco (Frank
Walsh)
SEC and
Criminal
Enforce-
ment
2002

Yes Yes 1
Disgorge-
ment;
Criminal
Fine
$22.5

Million
Fuqua
Duty of
Loyalty
2005

Yes
Insurer
Bankrupt

1 Settlement

Portion of
$7 Million
Paid by
Directors &

Officers
Ultra Vires Transaction
Lone Star
Steakhouse
Ultr
a Vires
2005

Yes Yes 4 Settlement

$54,400 +
Option
Repricing

Fuqua Industries’ directors had the misfortune of being insured by Reliance
Insurance, which went bankrupt. The case involved an alleged breach of the
duty of loyalty by Fuqua directors in approving a transaction between Fuqua
and a related company, Triton. The claim was derivative, so Fuqua could not
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1072 STANFORD LAW REVIEW [Vol. 58:1055
indemnify its directors for damages. Triton had gone bankrupt, so it too was not
available to pay damages. The inside manager who profited directly, J.B.
Fuqua, was apparently unable to pay the whole amount. The result was that
some of Fuqua’s outside directors made undisclosed settlement payments.
Fuqua serves as a reminder that a board’s approval of self-dealing transaction
by inside managers carries personal risk, even if the outside directors do not
profit directly. In similar cases discussed in Appendix B, outside directors were
found liable for such actions, but D&O insurance or the inside managers who
profited directly paid damages on the outside directors’ behalf. The Fuqua
directors were less lucky—they paid because neither of those sources was
available.
48

Independent Energy was a U.K. company that issued shares in the United
States and soon after went bankrupt due to fraud. Insurance was low and
contested. Four individual defendants contributed $2 million to settle a section
11 case. Most of this amount was paid by the former CEO, who was the
nonexecutive chairman during the class period, but our sources advised us that
two outside directors also contributed to the payment. The insurer and third-
party defendants made payments into the settlement as well.
49

Confidential Case #2 involved a coverage dispute between the company’s

insurers and the directors. Two insurers each sought to disclaim coverage on
different grounds. The directors were able to obtain early dismissal of the
lawsuit and then pursued a claim against the insurers to recover legal expenses.
They ultimately settled with the insurers for partial reimbursement.
50

Confidential Case #3 involved creditor claims for breach of the duty of
care against the directors of a bankrupt non-Delaware company. Insurance was
low, in part because the insurer providing one layer of coverage had gone
bankrupt. In addition, the remaining insurers contested coverage under the

48. See In re Fuqua Indus., Inc. Sec. Litig., Civ. No. 11974, 2005 Del. Ch. LEXIS 60
(May 6, 2005); Stipulation and Agreement of Compromise, Settlement and Release of
Claims, In re Fuqua Indus., Inc. Sec. Litig., Civ. No. 11974, 2005 Del. Ch. LEXIS 60 (Dec.
30, 2005); In re Fuqua Indus., Inc. Shareholders Litig., Defax Case No. D62090 (Del. Ch.
May 6, 2005), D
EL. L. WKLY., July 13, 2005, at D7. Fuqua advanced the defendants’ legal
expenses and agreed as part of the settlement not to seek reimbursement from the directors.
We were told that the outside directors’ payments were small relative to those of inside
managers.
49.See In re Indep. Energy Holdings PLC Sec. Litig., No. 00 Civ. 6689, 2003 U.S.
Dist. LEXIS 17090 (S.D.N.Y. Sept. 29, 2003) (describing personal payments of $2 million,
most of which was paid by former CEO Burt H. Keenan); Ben Wright, CSFB To Pay
Millions in US Legal Settlement, F
IN. NEWS ONLINE, Sept. 22, 2003,
/>9421. Keenan had left the CEO post and was an outside director during the class period, but
was still CEO for part of the period during which the fraud occurred, so we treat him as an
insider. However, there were payments by two clear outside directors as well. Telephone
Interview with Plaintiffs’ Lawyer (Dec. 16, 2005).
50. This case was described to us on a no-names basis. The terms of the settlement

agreement regarding sources of payment.
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February 2006] OUTSIDE DIRECTOR LIABILITY 1073
insured-versus-insured exclusion
51
but ultimately paid a portion of the
settlement. The directors were not protected by the equivalent of a Delaware
General Corporate Law section 102(b)(7) shield against duty of care liability.
Several outside directors paid a total of $300,000 to $400,000 and may also
have paid some of their own legal fees.
52

Peregrine Systems, still pending, is an oversight case that could result in an
out-of-pocket payment by outside directors. Company executives cooked the
books, the company went bankrupt in 2002, and it emerged from bankruptcy in
2005. A federal securities class action under section 11 and several state
securities suits are ongoing against a number of outside directors, including
founder John Moores, who has substantial personal wealth and was the
nonexecutive chairman at the time of the fraud. The D&O insurers have sought
to deny coverage, claiming application fraud. If the insurers’ defense succeeds,
the outside directors would likely face personal liability for both legal expenses
and damages. Meanwhile, the directors have been paying at least some legal
expenses out of their own pockets. We list Peregrine in Table 2 because the
policy is small enough, and the litigation extensive enough, so that full
recovery of these fees seems unlikely, even apart from the potential for a
damage payment.
53

We found two cases in which outside directors profited from transactions
with the company. One involved SEC and criminal enforcement against Frank

Walsh at Tyco based on an undisclosed $20 million finders’ fee for a Tyco
acquisition.
54
We discuss this transaction in Part III. The second, Lone Star
Steakhouse, was much smaller and involved a board decision to reduce the
exercise price on options the directors held. In a preliminary motion, the court
ruled that the board’s decision was ultra vires. In settling the case, the directors

51. See infra Part II.A.1.c.
52. This case was described to us on a no-names basis. It involved a claim by creditors
against the directors of a bankrupt non-Delaware company. The company apparently lacked
a shield protecting directors from damages claims arising out of breaches of the duty of care
akin to that authorized by section 102(b)(7) of the Delaware General Corporation Law.
Insurance was low and contested under the insured-versus-insured exclusion to coverage; in
addition, the insurer for one tier of coverage was bankrupt. The remaining insurer(s)
contributed to the settlement and may have paid some of the legal expenses.
53. See In re Peregrine Systems, Inc. Sec. Litig., Civ. No. 02cv870-J (Cal. Super. Ct.
Nov. 21, 2003). Claims against Moores and other outside directors brought under § 10(b) of
the Exchange Act of 1934 were dismissed in 2005, but claims under § 11 of the Securities
Act remain. See Bruce V. Bigelow, Fraud Claims v. Peregrine Ex-Directors Tossed Out,
S.D.
UNION-TRIB., Apr. 2, 2005, at C1. Peregrine agreed to reimburse Moores for some of
his legal expenses as part of its bankruptcy reorganization. See Bruce V. Bigelow, Moores,
Peregrine Settle for $1 Million; Ex-Chairman Asked More for Legal Fees, S.D.
UNION-
TRIB., June 14, 2005, at C1. Bernard Black has been retained as an expert witness by counsel
to Mr. Moores.
54.See SEC v. Walsh, SEC Litig. Release No. 17896, 2002 SEC Lexis 3193, at *1
(Dec. 17, 2002) (ordering disgorgement of concealed $20 million finder’s fee); Ben White,
Ex-Director of Tyco Arrested; Improperly Reported $20 Million Fee Will Be Returned,

W
ASH. POST, Dec. 18, 2002, at E1.
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1074 STANFORD LAW REVIEW [Vol. 58:1055
agreed to reset the options back to their original exercise price. One director
who had already exercised his options paid back his gains from the repricing.
55

An additional pending case that merits mention is Friedman’s Jewelers.
56

This case illustrates the difficulties an insurance coverage dispute can pose for
outside directors. The directors were sued under both section 11 of the
Securities Act and section 10(b) of the Exchange Act. They won dismissal of
the section 10(b) claims, but remained exposed under section 11. As in
Confidential Case #2, the D&O insurer has refused to advance defense costs to
the outside directors, and the outside directors are paying their own legal
expenses. At the time of this writing, a settlement appears likely in which the
outside directors will be covered for both legal expenses and damages. Even if
this occurs, however, the directors will still have lost the time value of money
for their legal expense payments and will have borne the risk that they would
not recover fully from the insurer.
C. The Bottom Line
In all, we found ten cases of out-of-pocket payments by outside directors
attributable to oversight failures—including the three well-known ones
(WorldCom, Enron, and Van Gorkom). We also found out-of-pocket payments
in two cases involving breach of the duty of loyalty and one involving an ultra
vires transaction. Several common themes emerge.
Among the cases of oversight failure, only Van Gorkom involved a solvent
company, and the basis of liability in that case was effectively overruled by the

Delaware legislature. The remaining cases involved insolvent companies. As
we explain in Part II, insolvency is essentially a prerequisite to outside director
liability for oversight failure. The duty of loyalty and ultra vires cases involved
solvent companies. Insolvency is not a factor with respect to out-of-pocket
liability risk in those contexts.
In addition, nearly all the cases in which the outside directors made
settlement payments involved either self-dealing or an oversight violation
subject to a negligence standard. The DoL case against Enron involved
ERISA’s negligence standard, but all others involved the negligence standard
provided for under section 11 of the Securities Act. As discussed in Part II, it is
easier for plaintiffs to prove claims under section 11 than under section 10(b) of
the Exchange Act or under state fiduciary duty law—and therefore easier to

55.See Notice of Pendency of Class and Derivative Action, Proposed Settlement of
Class and Derivative Action, and Settlement Hearing, Cal. Public Employees’ Retirement
Sys. v. Lone Star Steakhouse & Saloon, Inc., C.A. No. 19191 (Del. Ch. June 1, 2005); see
also Cal. Pub. Employees’ Ret. Sys. v. Coulter, 2002 WL 31888343 (Del. Ch. Dec. 18).
56.See In re Friedman’s, Inc. Sec. Litig., 385 F. Supp. 2d 1345 (N.D. Ga. 2005); Fed.
Ins. Co. v. Friedman’s, Inc., CIV No. 2004-CV-90701 (Ga. Super. Ct. 2004) (concerning
insurer’s claim for policy rescission); Interview with J. Marbury Rainer, Partner, Parker,
Hudson, Rainer & Dobbs LLP (Dec. 13, 2005).
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1075
obtain personal payments in settlements.
These two factors—insolvency and section 11’s negligence standard—are
elements of a scenario we describe in Part II as a “perfect storm.”
57
Enron,
WorldCom, Independent Energy Holdings, and Confidential Case #1 all fit or
came close to fitting this scenario.

The other securities cases involved companies with no D&O insurance or
D&O policy limits that were too low to cover the litigation expenses that would
be incurred by going to trial. In the latter set of cases, the insurer also
apparently had a strong basis for denying coverage altogether. With D&O
insurance low or absent, directors would pay, or risked paying, legal expenses
out of pocket even if they went to trial and won—a scenario we refer to below
as “can’t afford to win.”
58
In some of these cases (Baldwin-United and
Confidential Case #2), the directors did not make payments to settle with
plaintiffs, but they did pay legal fees personally. In Ramtek, a case involving a
settlement payment, settling for less than the legal fees they would incur by
going to trial understandably looked attractive to the directors. Confidential
Case #3, a creditors’ fiduciary duty case, was similar. The company was
bankrupt, so the directors’ litigation expenses would not be indemnified, and
the company’s D&O insurance coverage was low and contested.
Fuqua involved a loyalty claim and a bankrupt insurer. The company was
solvent, however, and therefore able to indemnify the directors’ legal expenses.
If, however, the case went to trial and the outside directors lost, their damage
payments would not be indemnified.
59
Not surprisingly, the directors in that
case chose to settle for a small fraction of potential damages rather than risk a
much larger loss at trial. As discussed in Part II, this is a scenario in which
outside directors faced with a derivative suit could be pressured to make
settlement payments.
Our search may have missed some instances of out-of-pocket liability, but
the fact that such an extensive search has found only a small number of cases is
strong evidence that the actual incidence is very low, and substantially lower if
directors are covered by D&O policies with reasonable limits and terms that

appropriately constrain the insurer’s ability to deny coverage.
60
One might
reasonably ask whether future liability risk will differ from past experience. A
principal source of concern is whether the “send a message” settlements in
WorldCom and Enron herald a new era of heightened risk. Our answer is that
past experience remains highly relevant. As we explain in Part II, the
infrequency of out-of-pocket liability reflects a complex interaction among
legal rules governing nominal liability, legal rules governing indemnification,
the terms of D&O insurance policies, and the incentives of parties to settle suits

57. See infra Part II.B.1.e.i.
58. See infra Part II.B.1.e.ii.
59. See infra Part II.A.2.d.
60. See infra note 121.
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1076 STANFORD LAW REVIEW [Vol. 58:1055
on terms that leave directors’ personal assets intact. The key elements of that
interaction remain largely unchanged—notwithstanding the send-a-message
motive that emerged in WorldCom and Enron. Consequently, especially if
outside directors are covered by state-of-the-art D&O policies, out-of-pocket
liability risk for oversight failure by outside directors will remain very low.
61

II.
WHY IS OUT-OF-POCKET LIABILITY SO RARE? A LEGAL ANALYSIS OF
SECURITIES AND CORPORATE SUITS
Among securities and corporate lawsuits that are not dismissed, why are
nearly all settled rather than tried, and why are they settled with no out-of-
pocket payments by outside directors? In any legal dispute, there is an inherent

bias in favor of settlement since both the plaintiff and defendant can save
litigation costs by avoiding a trial.
62
But there are forces specific to shareholder
suits that favor settlement even more strongly. These forces not only lead
parties to settle, but they also lead them to settle on terms that leave the outside
directors’ personal assets intact. This Part analyzes why this situation has been
true in the past and assesses whether the legal environment has changed in a
way that is likely to increase the incidence of out-of-pocket liability for outside
directors in the future.
There are two scenarios in which outside directors potentially bear out-of-
pocket liability as a result of a shareholder suit. First, the plaintiffs may pursue
a case through trial to judgment and obtain a damage award against the outside
directors. For the damage payment to come out of the outside directors’
pockets, however, certain conditions must be present which prevent the
directors from being indemnified by their company or another source
63
or
covered by D&O insurance. The second scenario is one in which the plaintiffs
settle with the outside directors for a payment that is neither indemnified nor
covered by insurance. For the outside directors to agree to such a settlement,
the plaintiffs must be able to credibly threaten to go to trial, under
circumstances in which the trial might lead to out-of-pocket liability.
Part II.A analyzes the scope of out-of-pocket liability if a case is pursued
through to judgment. The legal rules that determine whether a judge will hold a
director liable are summarized. The legal rules governing indemnification, and
the terms of D&O insurance policies, are then analyzed in order to identify the
scenarios in which this nominal liability will translate into out-of-pocket
liability for an outside director. Against this background, Part II.B analyzes
settlement dynamics that occur in the shadow of out-of-pocket liability risk and

identifies the scenarios in which outside directors may make out-of-pocket

61. On what constitutes a state-of-the-art D&O policy, see infra note 121.
62. S
TEVEN SHAVELL, FOUNDATIONS OF ECONOMIC ANALYSIS OF LAW 401-03 (2004).
63. Other potential sources of indemnification include controlling shareholders,
venture capital funds, or other organizations with which the outside director is affiliated.
BLACK ET AL. 58 STAN. L. REV. 1055 3/9/2006 12:21:03 AM
February 2006] OUTSIDE DIRECTOR LIABILITY 1077
payments to settle a case. Part II.C analyzes the WorldCom and Enron
settlements in the light of the analysis in Parts II.A and II.B.
A. The Scope of Out-of-Pocket Liability Risk if a Case Is Pursued to Judgment
Most shareholder suits brought against outside directors of public
companies take the form of class actions brought under the securities laws. The
others are suits for breach of fiduciary duty brought under state corporate law.
In some instances, the same transaction may prompt both types of suit. For
each of these sources of potential liability, this Part identifies the circumstances
under which an outside director can be held liable at trial for damages and then
describes the additional factors that must be present for indemnification and
insurance to fail to provide full protection against out-of-pocket liability. We
show that, so long as an outside director has not engaged in self-dealing, the
scope of potential out-of-pocket liability is very narrow.
1. Securities lawsuits
A typical securities class action seeks damages on the grounds that the
company has misled investors either by saying something material that is
untrue or misleading or by failing to say something material. The defendants
typically include the company itself, the CEO, and other specified company
executives, often including the chief financial officer (CFO). Outside directors
are named in some cases,
64

as are the company’s auditor and investment
banker.
There are two basic causes of action. One is a claim under section 11 of the
Securities Act of 1933, which provides that those responsible for a registration
statement issued in connection with a public offering may be liable if there is a
material misstatement or omission in the registration statement or related
documentation.
65
The other is a claim under section 10(b) of the Exchange Act,
under which those responsible for material misstatements or omissions on
which investors have relied in secondary trading can incur liability.
66
Damage

64. Preliminary data that Bernard Black, Elaine Buckberg, Michael Klausner, and Ron
Miller have collected for a separate article indicates that, from 2000 to 2003, outside
directors were named as defendants in nineteen percent of securities class actions. Among
section 11 cases, which comprise fifteen percent of cases during this period, outside directors
are named fifty percent of the time. Among section 10(b) cases, they are named thirteen
percent of the time.
65. Securities Act of 1933 (Securities Act) § 11, 15 U.S.C. § 77k (2006).
66. Claims under section 11 are often accompanied by claims that the directors should
be liable as control persons under section 15 of the Securities Act. See Securities Act § 15,
15 U.S.C. § 77o (2006). Claims under section 10(b) can similarly be accompanied by claims
that the directors should be liable as control persons under the Exchange Act section 20(a).
See Securities Exchange Act of 1934 (Exchange Act) § 20(a), 15 U.S.C. § 78t(a) (2006).
We do not address control person liability in this Article, but the addition of a control
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1078 STANFORD LAW REVIEW [Vol. 58:1055
actions are also possible under section 14(a) of the Exchange Act for

misdisclosure in a proxy statement and under section 9(a) of the Exchange Act
for manipulating securities prices, but these claims are far less common, and we
do not address them here.
a. Risk of nominal liability under the securities laws
If a registration statement contains a material misstatement or omission,
section 11 of the Securities Act provides that an outside director is liable to
those who purchased securities unless the director succeeds in proving a due
diligence defense. To succeed in this defense, a director must prove (1) that he
engaged in reasonable investigation; (2) that with respect to those portions of
the registration statement based on the authority of an expert, the director had
no reasonable ground to believe, and he did not in fact believe, that any
information was untrue; and (3) that with respect to other portions of the
registration statement, he had reasonable grounds for believing that the
registration statement was true.
67
“Reasonable investigation” and “reasonable
grounds” are judged under a negligence standard. Thus, in effect, outside
directors are subject to a negligence standard under section 11—a standard that
is substantially more favorable toward plaintiffs than the liability standard
applicable under section 10(b) or the liability standard applicable in fiduciary
duty cases under state corporate law.
Under section 10(b), plaintiffs must prove that a defendant responsible for
a material misstatement had scienter. Verbal formulas for scienter vary among
circuit courts, but scienter is generally understood to require, at a minimum, a
high degree of recklessness with regard to the truth, approaching conscious

person claim to a section 11 or section 10(b) claim probably does not increase an outside
director’s out-of-pocket liability risk. One reason is that each control person claim requires
proof of a mental state that is similar to the mental state required under section 11 and
section 10(b) respectively. See, e.g., In re Enron Corp. Sec., Derivative & ERISA Litig., 258

F. Supp. 2d 576, 597-98 (S.D. Tex. 2003); In re Initial Pub. Offering Sec. Litig., 241 F.
Supp. 2d 281, 351-52, 392-98 (S.D.N.Y. 2003); see also 4 A
LAN R. BROMBERG & LEWIS D.
LOWENFELS, BROMBERG AND LOWENFELS ON SECURITIES FRAUD AND COMMODITIES FRAUD
§ 7:353 (2005) (describing the cases discussing the good faith defense as “highly fact
specific,” making it “difficult to extract guiding legal principles”). See generally Loftus C.
Carson, II, The Liability of Controlling Persons Under the Federal Securities Acts, 72
N
OTRE DAME L. REV. 263 (1997).
The proportionate liability rules that serve to protect outside directors under section 11
and section 10(b) seem to apply to control person liability as well. The point is addressed
explicitly in section 20(a) of the Exchange Act. The issue has never arisen specifically under
section 15 of the Securities Act, but if proportionate damages do not apply under section 15,
Congress’s intent in creating proportionate liability under section 11 would be undermined.
One would therefore expect the same damage rule to apply. For these reasons we do not
address control person liability.
67.See Securities Act § 11(a)(2), (b)(3), 15 U.S.C. § 77k(a)(2), (b)(3) (2006); J
OHN C.
COFFEE, JR. & JOEL SELIGMAN, SECURITIES REGULATION: CASES AND MATERIALS 875-915
(9th ed. 2003) (discussing the due diligence defense).
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February 2006] OUTSIDE DIRECTOR LIABILITY 1079
disregard of truthfulness or conscious knowledge of untruthfulness.
68
A
defendant’s motion to dismiss a suit brought under section 10(b) will be
granted unless the plaintiff pleads “with particularity facts giving rise to a
strong inference that the defendant acted with the required state of mind.”
69

The strong inference requirement at the pleading stage for a section 10(b)
action poses a substantial hurdle for a plaintiff seeking to bring a case against
outside directors. Without the benefit of discovery, the plaintiff must allege
specific facts that support its claim that the directors had the scienter required
under section 10(b).
70
Because outside directors are ordinarily not involved in
the day-to-day operation of the company, plaintiffs often have no basis for
establishing a strong inference against the outside directors when a material
misstatement or omission has occurred.
71
Such an inference is possible in some
circumstances, such as when the outside directors fail to investigate reports of
problems in their company
72
or sell a suspiciously large number of shares
shortly before bad news is released.
73
Commonly, however, evidence
supporting the required inference will be unavailable, and plaintiffs will either
not include outside directors as defendants in section 10(b) cases, or the outside
directors will succeed in having the claims against them dismissed at a
preliminary stage.
74


68.See Exchange Act § 10(b), 15 U.S.C. § 78j(b) (2006); Exchange Act Rule 10b-5,
17 C.F.R. 240.10b-5 (2006); COFFEE & SELIGMAN, supra note 67, at 1117-30 (discussing the
culpability standard under Rule 10b-5). For forward-looking statements the culpability
standard is actual knowledge under both the Securities Act and the Exchange Act. See

Securities Act § 27A(c)(1)(B), 15 U.S.C. § 77z-1(c)(1)(B) (2006); Exchange Act
§ 21E(c)(1)(B), 15 U.S.C. § 78u-5(c)(1)(B) (2006).
69. Exchange Act § 21D(b)(2)-(3), 15 U.S.C. § 78u-4(b)(2)-(3) (2006).
70. See, e.g., Part III.B.3, infra (discussing the WorldCom and Enron cases, in both of
which 10(b) claims against the outside directors were dismissed); In re Reliance Sec. Litig.,
135 F. Supp. 2d 480, 506-08 (D. Del. 2001) (dismissing defendant outside directors’ motion
for summary judgment because a reasonable juror could find that outside directors had
requisite scienter). It is not enough to show that the director signed an inaccurate disclosure
document. See In re Sensormatic Elecs. Corp. Sec. Litig., No. 018346CIVHURLEY, 2002
WL 1352427, at *5 (S.D. Fla. June 10, 2002) (granting outside director’s motion to dismiss
on grounds that an allegation that the director was an audit committee member and signed
the company’s annual Form 10-K does not satisfy the section 10(b) pleading standard).
71.See J
AMES HAMILTON ET AL., RESPONSIBILITIES OF CORPORATE OFFICERS AND
DIRECTORS UNDER FEDERAL SECURITIES LAWS ¶ 308 (1997).
72. See, e.g., In re Lernout & Hauspie Sec. Litig., 286 B.R. 33, 37-38 (D. Mass. 2002)
(finding that directors ignoring auditors’ warnings about lack of internal controls was
sufficient to state a claim under the Securities Exchange Act).
73. Plaintiffs allege insider trading in more than half of shareholder class action
complaints. See Jordan Eth & Christopher A. Patz, Securities Litigation and the Outside
Director, R
EV. SEC. & COMMODITIES REG., May 9, 2000, at 95, 101. Outside directors can
protect themselves from a claim of suspiciously timed stock sales by refraining from selling
shares while on the board or, if they do need to sell stock, by taking advantage of securities
regulation “safe harbor” by selling on a preestablished schedule. See Exchange Act Rule
10b5-1, 17 C.F.R. § 240.10b5-1 (2006).
74. Eth & Patz, supra note 73, at 101, 104.